Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Are U.S. equity funds a buy based on their underlying valuations? Joining me to discuss some recent research on that topic is Laura Lallos. She is a senior mutual fund analyst with Morningstar.

Laura, thank you so much for being here.

Laura Lallos: Thank you.

Benz: You recently took a look at the universe of funds that are in the Morningstar 500. Those are the funds we track in Morningstar FundInvestor. And the idea was to take the price/fair value ratios that our equity analysts assign to individual stocks and actually look at funds and attempt to figure out whether they are overvalued, undervalued, or fairly valued. So, let's start by talking about how our equity analysts arrive at those fair value statistics?

Lallos: Well, our equity analysts have their own proprietary discounted cash flow models to arrive at what they think is a fair value for the stocks they cover. And then based on that they can look at price/fair value ratios and determine whether a stock is fairly valued or a good buy today.

We noticed that looking at the median stock they cover, right now it's just about fully valued. And to put that in perspective, last June the median stock they covered was 85% of fair value. So we can see the recent stock rally reflected there.

Benz: Laura, in terms of the methodology, when you look at a whole mutual fund, how do you go about finding the price/fair value? Is it an average or weighted average? What are you doing there?

Lallos: We did an asset-weighted average, and we wanted to be sure that our calculation truly reflected the portfolio. So, we only looked at funds for which we had our equity analysts covering at least 75% of a particular fund's assets, so that we could say, yes, this is a reasonable reflection of the portfolio.

Benz: When you looked at the equity fund universe, the funds in the Morningstar500, it wasn't a super-encouraging picture. So, let's talk about the research and also whether you saw any gradation? So, did the value funds look cheaper than the growth funds? Let's talk about your overall findings.

Lallos: Overall, we found that, yes, large-cap mutual funds seem to be just about fairly valued. The Vanguard 500 Index fund, for example, had a price/fair value ratio of just about 1. We did see, as you might expect, that value funds tended to fall in a lower range than growth funds with blend funds falling in the middle, but overall they were all tending to be approaching fair value.

Benz: When you dug in a little bit though, Laura, and looked for those funds that did have pretty attractive price/fair value ratios, let's talk about some of those names. They will be familiar names to a lot of our viewers and readers because they have been some of our favorite value funds over time, Oakmark, some of the Oakmark funds were on the list.

Lallos: Right. Bill Nygren's portfolio one of the more attractively valued options by this measure. Interestingly, he has been warning about certain areas that are considered traditional value areas like dividend-paying stocks, he has been warning over the past year that these are too expensive. And he has been avoiding that area, and his portfolio is one that indeed looks like a good deal right now.

Benz: And Davis New York Venture I know was another one?

Lallos: Exactly. In a similar vein, Chris Davis and Ken Feinberg, they are also more kind of classic value investors, and they too have put together a portfolio that by our measure looks like a good deal.

Benz: So, you mentioned the dividend space, Laura, and I thought that was an interesting part of your research. There has been this stampede of investor dollars going into those funds, and when you looked at the price/fair value ratios for some of those funds that have "dividend" in their name, what you found was not super-encouraging from a price/fair value measure.

Lallos: Right. In both the large-cap value and the large-cap blend categories, the most expensive portfolios were dividend-oriented funds. Both funds that focus on high-yielding stocks and even funds that aren't looking for the highest yields out there but are looking for funds with growing dividends, these have been very popular areas and it's showing up. They are showing up as pretty much almost fully valued.

Christine Benz: So on the growth end of the spectrum, you mentioned that in general the value-oriented funds were looking a little bit more attractive on this measure, but you did find a couple of outliers, funds that do have a growth tilt that appear to be pretty attractive based on these price/fair value ratios. Let's talk about a couple of names there.

Lallos: Right, one is Jensen Quality Growth, and this wasn't a surprise. These are managers who've always been more attentive to prices than most other growth managers are. And their portfolio reflects that today. Another example is Vanguard PRIMECAP Core, another team that they want growth, but they also wait to buy until they have attractive valuations.

Benz: That's a fund I own, so I am glad to hear that it has some upside perhaps ahead. Say, I am looking at this list and looking at these overall findings, it's not terribly encouraging to think of the average price/fair value ratio of the, say, the S&P 500 Index as being pretty close to right in line with fair value. But how should I think about this research? Does this mean that I want to pull back on stocks? How should I employ this when thinking about my own portfolio oversight?

Lallos: It definitely doesn't mean that people should pull back on stocks. No one is arguing that the bond market is a great value right now.

Benz: That's true.

Lallos: But it is a good reminder that certain types of stock funds maybe aren't the best deals right now. As we said the dividend-oriented funds or even a very broad stock market fund [are close to fairly valued]. Perhaps now is a good time to look for managers who are more attentive to price. Perhaps now is also a good time to think about dollar cost averaging; maybe this isn't the time to go all in.

Benz: And I noted one thing in your report too, Laura. You said for people who kind of want this intelligence on an ongoing basis, we have that fair value Quickrank tool on Morningstar's ETF page. So even though you can't do it for mutual funds, you can see it for ETFs.

Lallos: You can.

Benz: Well, thank you so much for being here. This is very interesting research.

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